What to Expect When P/E Multiples Compress

In the past three years, as the major stock indexes have appreciated, public-company valuations have stretched to progressively higher multiples of earnings. These valuations have increased1 at the same time as the average S&P 500 constituent company has generated unusually high earnings on each sales dollar.

Some argue that because of the relative attractiveness of the U.S. economy and the unattractiveness of bonds, the stock market has much more room to run. So it may. However, the market can now lose in two obvious ways: valuations, as multiples of earnings, may fall to historical norms, and companies’ earnings may fall should operating margins revert toward historical averages.

Given these risks, it is worthwhile to consider which approach will serve you best in the uncertain periods ahead – focusing on investing in the best companies, or aiming to find the lowest priced opportunities? It also is a good time to ask how value-oriented investment approaches, such as Joel Greenblatt’s “magic formula”, would have performed when price-to-earnings multiples compressed in the past? A recent study we completed yields some perspective on these two questions.

The “magic formula”

Joel Greenblatt is a prominent value investor who wrote the easy-to-read book, The Little Book That Beats The Market. In his book, Greenblatt presented a “magic formula” for buying what he considered to be good companies at good prices. He also shared evidence that one would have achieved a better-than-market return by adhering to his formula from 1988 to 2004.

Greenblatt’s concepts – good companies and good prices – are represented by two financial statement ratios: a high return on invested capital (ROIC) represents a “good company,” and a high earnings yield (EY) represents a “good price”2. The definitions of both ratios used in our study are provided in the footnote. Here is an easy way to think about them:

ROIC tells you how much cash a company generates in relation to the amount of capital tied-up in its business. As ROIC numbers increase, all else being equal, a business gets better and better. The reason is that the higher a business’s ROIC, the more money it pockets each year in relation to the money that has been invested in the business.

EY tells you how expensive a company is in relation to the earnings the company generates. When looking at EY, we make certain adjustments to a company’s market capitalization to estimate what it would take to buy the entire company. This involves penalizing companies that have a lot of debt and rewarding others that have a lot of cash.

Greenblatt’s magic formula gives these two ratios equal weight when selecting investments. His formula ranks all companies in the investable universe by good company (ROIC) and good price (EY). Then, each company’s ROIC and EY ranks are added together. Greenblatt’s formula has investors buy companies with the best combined rankings, hold each company for a year and then rebalance by investing in new highly ranked companies.

Our two questions

We examined two questions about Greenblatt’s formula as part of the study:

When selecting investments, what matters more: investing in good companies or making investments at good (that is, low) prices? Put another way, should EY and ROIC be weighted equally? What occurs if one is given more weight in the ranking system?

Greenblatt’s study focused on the period from 1988 to 2004. How would this approach have performed across a longer period of time? Are there interim periods when this approach might have done well or poorly?

We hope you find our insights informative regarding the magic formula itself and also how this strategy of buying good companies when they are “on sale” performed during periods when the average company’s valuation contracted as a multiple of earnings.